Software Will Fare Better Than The Broader Tech Sector In 2020 And 2021, But The Impact Will Vary Among Subsectors

The COVID-19 pandemic, the subsequent economic downturn, and changing work and education patterns are imposing wide-ranging changes across the technology industry--and the software subsector is no exception. Although we believe software will be more resilient to a prolonged economic downturn than the rest of the sector due to an increasingly subscription-focused revenue model, the impact on individual firms will vary widely. We expect that the events of this year will bolster the already substantial competitive advantage enjoyed by firms able to support clients' digital transformations through SaaS (software as service) offerings as opposed to those wedded to legacy architectures, lengthy onsite sales and implementation cycles, and on-premise applications.

Connectivity, security, and education software providers should be the best positioned to capitalize on the changes in education and the workplace. We expect that:

• Firms that are able to provide connectivity and communications technology will benefit from increasing spending on infrastructure to support working from home, a trend that we believe will persist past the immediate COVID-19 impact.
• Security software will grow in importance, particularly applications that can protect a greater variety of remote work environments and cloud-based applications, such as identity and access management and CASB (cloud access security broker) providers.
• There will be strong growth opportunities for firms that support remote education as more educational institutions rely on remote learning to reduce infection risk.

By contrast, we expect that firms that are highly focused on sectors that have been affected by COVID-19--including retail, hospitality, and oil and gas--will underperform, even if they have highly cloud-dependent models. In addition, high exposure to the small and midsize business (SMB) sector will be a significant risk factor, as these firms have disproportionately borne the brunt of the slowdown so far. Nevertheless, cloud-native providers that are suffering mainly due to end-market exposure should face mostly short-term pain until the broader economy recovers. By contrast, legacy vendors could simply face an acceleration of their ongoing long-term decline, even if they have a relatively insulated customer base.

Connectivity Providers Will Benefit From Persistent Remote Working

Most companies now rely on an array of communication and collaboration tools as part of employees' daily workflows. These include email, messaging, video and audio conferencing, and IP and private branch exchange (PBX) voice calls. These services are increasingly bundled on unified communication platforms like Microsoft Teams. Given SMB's relatively modest IT infrastructures and asset bases, we have found that they have generally been faster to adopt cloud-based communication platforms. They do so to benefit from a more scalable and flexible deployment model with faster upgrade cycles and typically lower upfront ownership costs. However, the work-from-home dynamic since March has materially boosted the rate of cloud adoption among large enterprises, which have been pushed to migrate to ensure that collaboration and productivity are not hampered by lack of access to on-premise IT infrastructure.

Because we expect remote working and employee mobility to remain prevalent even after the pandemic, we believe that demand for cloud-based video and audio conferencing and collaboration tools will remain robust in the long run. This fares well for rated companies with strong cloud offerings in this market like Microsoft (Skype and Teams), LogMeIn (GoToMeeting), Intermedia Holdings (Unite and AnyMeeting), and Avaya (Avaya Cloud Office, through its recent partnership with RingCentral). Cisco and Webex will also benefit.

Table 1

Security Is Increasingly Critical As The Network Edge Expands

Security and data protection software companies with strong cloud and remote device security offerings are also likely to benefit from the migration of more workloads to public cloud environments to support remote working. The increasing share of work performed away from the corporate office, and instead through cloud-based applications, exposes firms to new and more complicated data security risks. Companies with modern offerings that support this transition should be well-positioned to grow through 2020 and beyond.

There are a wide range of security and data protection solutions that are relevant in cloud environments. These include identity access management, data governance, data backup and archiving, endpoint security across mobile devices, and network security and monitoring. We expect issuers with comprehensive and integrated solutions across public cloud, private cloud, and on-premise solutions will especially benefit from large enterprise migrations. Many customers in end-markets such as financial services will likely want to keep some workloads on-site or in private cloud environments. This is because they might need to maintain greater control over security and operations for mission-critical, sensitivity, or regulatory reasons. While this is a fragmented market, companies that stand to benefit include Ping Identity, Barracuda, InfoBlox, and Imperva. Traditional legacy enterprise security providers with substantial exposure to on-premise endpoints such as McAfee and Symantec Enterprise (now part of Broadcom) will struggle to grow, in our view.

Given the highly fragmented and startup-rich security software landscape, we expect a high level of acquisitions in the coming years. This will come from both broader communications and cloud providers seeking to build out their own native security offerings as well as legacy security incumbents targeting faster-growing areas to enhance their product portfolios.

Table 2

Education Spending On IT Will Grow To Support Remote Learning

The K-12 education sector has lagged many other sectors in technology adoption. While we had expected K-12 schools would become more tech-enabled over time as they pushed for efficiencies and as teachers became increasingly comfortable operating with technology, COVID-19-related school closures and the shift toward remote learning have accelerated this trend. Edtech firms that provide remote learning or learning management systems (LMS)--such as Blackboard, Renaissance, and Weld North Education--have observed that their existing customer bases' usage increase significantly when shelter-in-place restrictions are in effect. Some firms are allowing existing customers to expand usage to additional students and products for free to build goodwill, which they hope will lead to new contracts when school budgets are more certain.

For edtech firms with end-markets in higher education, we view the trends more on a case-by-case basis. We anticipate that firms that provide student information systems (SIS) and financial and human resources products like integrated Enterprise Resource Planning (ERP) software (Sophia L.P. and Astra Acquisition Corp.) will experience little negative impact from COVID-19 over the next year due to the entrenched nature of the products and high switching costs.

We see more risk for edtech firms with revenue models that have campus or transactional-based revenue models. One clear example is Transact Holdings Inc., a firm that provides software that facilitates on-campus payments for university students. We downgraded Transact to 'CCC+' in April due to our expectation that disruption to higher education would lead to significant revenue declines and liquidity challenges. Less dramatically affected firms include LI Group Holdings (doing business as Liaison), which provides centralized application services for graduate students. This company is significantly dependent on student applications volume for revenue. Campuses closures, remote learning, and increased cash hoarding by consumers during these uncertain economic times could result in declining student applications. In addition, travel restrictions or changes in immigration policies could further pressure the application volume for U.S. colleges and universities.

Table 3

Firms Heavily Exposed To Troubled Industries And Aging Legacy Technologies Will Experience The Greatest Negative Impact

We expect firms with offerings that are closely tied to legacy platforms, on-premise architecture, and are reliant on perpetual license revenue models to suffer most from the downturn, particularly as license sales are likely to lag as customers delay spending on projects non-essential to shifting the workforce remote. We also view firms focused on these older platforms and delivery methods to be most likely to suffer a long-term impact from a COVID downturn, even as the broader software industry recovers, as the growth in cloud spending is an acceleration of an ongoing trend unlikely to reverse. Many of the negative rating actions we have taken so far in the software space include firms that have significant exposure to legacy technologies, such as Rocket Software and ASG Technologies Group Inc. Legacy companies with negatives outlooks include Starfish Holdco and Veritas Holdings.

We also see risk for companies heavily focused on industry verticals such as hospitality, events, retail, or energy. There is also risk forcompanies with high exposures to SMBs, though this risk exposure is more idiosyncratic. Although since the pandemic, we have downgraded several of these firms or revised the outlooks to negative, we see greater potential for them to recover with the general economy over time. Companies in this category include retail-focused providers Blackhawk Network Holdings and Aspen Jersey Holdco, oil and gas ERP provider QBS Parent Inc., and SMB-focused Eclipse Midco and Datto Inc.

Although so far COVID-19-related rating actions in the software sector have been limited compared to hardware issuers, extremely aggressive financial policy and heavy financial sponsor involvement in the software industry leave many firms with limited ability to weather a downturn, regardless of their business model and end-market exposures.

Table 4

COVID-19 Will Accelerate Ongoing Trends And Sharpen Contrasts, But Software Broadly Will Continue To Grow

The software industry continues to transition to cloud-delivered subscription based business models, and the impact of increasing remote work and education has only accelerated that transition. We expect the divergence in performance between cloud-native and legacy software providers to accelerate beyond what we had expected going into 2020, and companies with compelling connectivity, security, and education-related offerings will see a growing opportunity set. Although providers with oversize exposure to industry verticals hit hard by pandemic effects will likely see near-term pain, we generally expect them to recover as long as they can adapt to the new enterprise IT architecture and deliver and support their products remotely. While most of investment-grade software companies have ample balance-sheet strength to weather this transition, increasing leverage at sponsor-owned firms will give companies poorly prepared for the post-COVID world little room to adapt.